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Investment Overview for Microsoft (NASDAQ:MSFT)

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Below are key drivers of Microsoft's value that present opportunities for upside or downside to the current Trefis price estimate for Microsoft:

Microsoft Office

Microsoft Share of Productivity Software market: We currently forecast Microsoft's market share of Productivity software to decline from about 93.1% in 2014 to 91% by the end of the Trefis forecast period in 2021. We believe that increasing competition from cloud computing players like Google could cause market share declines. However, Microsoft's Office 365, a web-based cloud version of its Office productivity suite, is gaining traction among users. There could be an upside of more than 5% to the Trefis price estimate if Microsoft is able to maintain its market share throughout. However, if Google is able to capture large market share at the expense of Microsoft, there could be a downside of 5% to the Trefis price if Microsoft's market share declines to 85% by the end of Trefis forecast period.

Microsoft Office Operating Margin: We currently forecast Microsoft Office operating margin to decline from about 64% in 2014 to nearly 58.7% by the end of the Trefis forecast period. The margin decline is primarily due to the introduction of lower priced Office 365. There could be a downside of approximately 10% to the Trefis price estimate if its margins decline to around 40% by the end of Trefis forecast period.

Windows Server And Sql Servers

Server Software Price per Server : We currently forecast Microsoft’s average selling price to decline from 153,000 in 2014 to 133,000 by the end of our forecast period, primarily due to pricing pressures from clients and change in mix towards low end cheaper versions. There could be an upside of more than 2% to the Trefis price estimate if Microsoft is able to maintain its software price at current levels by the end of our forecast period. However, if it were to decline to 100,000, there could be a downside of 3% to the Trefis price.

Windows Share of Global Server : We currently forecast Microsoft's market share server software to remain stable at 75.3%. We believe that as dependence on cloud computing is increasing and so is the demand for SQL server software that can support high number of queries and data manipulation. There could be an upside of more than 1% to the Trefis price estimate if Microsoft’s marketshare in server software industry increases to 80%. However, if the market share were to decline to 70%, there could be a downside of 2% to the Trefis price estimate.

Windows Server and SQL server Operating Margin: We currently forecast operating margin for this division to decline from about 39.7% in 2014 to nearly 35.3% by the end of the Trefis forecast period. The margin decline is primarily due to intense competition from companies such as SAP, Oracle etc. There could be a downside of approximately 5% to the Trefis price estimate if its margins decline to around 30% by the end of Trefis forecast period.

Windows Operating System

Microsoft's Market Share of PCs: We currently forecast Microsoft's market share of PCs to decrease slightly to approximately 76% by the end of the Trefis forecast period. We believe that the new version of Windows 8 - Windows 8.1 - will see at least as many license sales as Windows 7. Considering the recent withdrawal of support for Windows XP, we expect Windows license sales to gain more traction in the coming quarters. However, the company plans to launch Windows 10 in mid of 2015, which should fillip sales post release. There could be a downside of more than 5% to the Trefis price estimate if our forecasts fail to materialize, and Windows market share declines to 55% by the end of our forecast period. Other factors that could contribute to a decline would be the popularity of competing OS's such as Apple's Mac OS X, Google's Chrome OS, and Linux.

Global Notebook & Netbook market: We conservatively forecast global notebook and netbook market to increase from 179 million in 2014 to 202 million by the end of the Trefis forecast period, an compounded annual growth rate of around 1.7%. This growth is much less than the average growth of 24% achieved in the past few years. We believe the primary reason for this slow growth will be the advent of tablets, which could cannibalize sales of low-cost notebooks and netbooks. However, there could be an upside of more than 10% to the Trefis price estimate if the notebooks & netbooks market grows to 250 million by the end of our forecast period.

Windows OS Operating Margin: We currently forecast Windows OS operating margin to decline from about 38.7% in 2014 to nearly 32% by the end of the Trefis forecast period. Although, the netbook sales has translated into growth in Windows license sales, it has lowered the average license pricing, as netbook OS licenses are typically much cheaper than notebook or desktop licenses. This has caused margin declines in the past. However, the increasing popularity of premium ultrabooks could boost the average Windows license pricing, and thus its margins. There could be an upside of 5% to Trefis price estimate if it is able to maintain its margins at around 50% in future.

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Microsoft makes money primarily through the sale of software server licenses, business productivity and operating system software. Microsoft's business productivity software suite, known as MS Office, is used for word processing, spreadsheet preparation, presentations and email. MS Office is sold primarily to businesses worldwide. Microsoft's operating system software, known as Windows, is sold primarily to PC manufacturers (such as Dell, HP, Acer), which sell Windows-based PCs to consumers and businesses. Its Server software include MS SQL Server and Windows Server that is sold to application development companies.

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We believe Microsoft Office and Windows Server and SQL Server are the most valuable segments of Microsoft for the following reasons:

MS Office Has High Market Share

Microsoft Office has higher market share in the productivity market compared to the market share Windows OS has in the PC market. Even if users use Mac OS X over the Windows OS for their personal computing needs, Microsoft's Office Suite is still one of the best available productivity suites on the platform. Even as more competition enters the productivity software industry, we still think that Office is substantially better than competing products.

Popularity of Windows And SQL Server

Due to increase in activity on the Internet, big data analytics has come to fore. As a result popularity of SQL server is on the rise. Furthermore, Microsoft's Azure platform has resulted in increase in sale of its virtualized version of its Windows server.

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Threat of Google Docs to Eat Into Office Margins

Microsoft Office operating margins were around 64% in 2014. Microsoft released Office 365, a cloud-based software, to compete with Google Apps. Under the cloud-computing model, Microsoft would store Office programs on its own servers and deliver them to customers online. Although this is more cost-effective for its customers, cloud-based Office software will cost Microsoft more when compared to supplying software that is installed on the computers and servers of customers. If Microsoft willingly ends up cannibalizing some of its own business productivity products, it could be due to fears that competition and mobile apps are a serious threat to its business long-term and would pressure margins anyway.

Microsoft faces headwinds in tablet market

Microsoft launched the next version of Windows 8 - Windows 8.1 - in 2013 which improved the user experience on notebooks as well as tablets. While company's initial Surface tablet was hit with negative reviews, Surface Pro 2 gained some traction amongst users. However, as the competitive tablet industry has already established products such as the Apple's iPad and Google's Android tablets, Windows tablets faces strong headwinds as it tries to increase market penetration.

Acquisition of Nokia Phone division could benefit Microsoft

Microsoft acquired Nokia's phone division in 2013. The company is using this division to markets its Windows Phone OS in the developing market from where consumers are price sensitive and most of the new growth in smartphone industry is expected to come.

Netbooks and cheaper laptops took shape as a phenomenon in 2008 and have started to account for an increasingly larger proportion of the PC market since their launch. Netbooks are targeted towards price-conscious consumers and are used to primarily run web-centric applications like email and the Internet, where the OS requirements are light. This has lead PC OEMs to be more willing to look at lower- priced, reasonably capable alternatives to Windows, such as Linux. To counter this trend Microsoft cut Windows 8.1 licensing cost by 70% to boost its popularity amongst cheaper PC’s and tablet. We expect that this trend will dilute Microsoft's pricing and margins.

Growing Threat from Google Apps

We expect that Microsoft's Office suite will continue to experience challenges from hosted solutions like Google Apps, as well as open source alternatives, such as Star Office.

Increased Marketing of Microsoft's New Bing Search Engine

In June 2009, Microsoft unveiled its newly-positioned search engine called Bing. Microsoft is believed to have spent hundreds of millions of dollars on marketing and promoting Bing, which is primarily why its Online Services division continues to be in the red, but is turning around.

Piracy Remains an Issue

Piracy is an important issue for Microsoft as software piracy in emerging markets is particularly problematic. The problem is grave in China, as some of its biggest organizations (and some segments within government itself) use a large proportion of pirated software. For example, Microsoft estimates that 84% of the Office software and 97% of Windows server software used at China Railway Construction Inc. is pirated.

If the Chinese government fails to crackdown on these piracy issues, Microsoft will be left out of a lucrative Chinese market.

How Does Trefis Modelling Work?

How do we get the historical numbers for this chart?

Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.

Who came up with the Trefis forecast for future years?

The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.

How does my dragging the trendline on the chart impact the stock price?

We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.

We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

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